Why the Real Estate [Asset] Class System Needs Dismantling

Imagine you’re camping in the remote wilderness. It’s night and a storm is moving in. You go to set up your tent, but the ground is too hard to sink the stakes by hand. What do you do? Do you attempt to run back to civilization in a dark storm? Do you wrap yourself in your invertebrate tent hoping it’ll shield you from the elements overnight? Or do you look for something — perhaps a stone — to act like a mallet and drive the stakes in?

Experienced campers know it’s neither possible, nor preferable, to have the exact piece of gear for every eventuality, because single-function items like a mallet don’t justify the amount of energy it takes to carry them. Therefore, the choice to use a stone as a mallet is an easy one. The stone might lack a mallet’s handle and precision, but it performs the task that’s needed to drive the stakes, pitch your tent, and get through the night safely.

Now imagine the problem isn’t driving stakes, but accessing affordable housing. Your budget is $1,000/month for rent, but your area lacks homes within your budget. While there are no homes in your budget, your town has 300,000 square feet of unleasable office space and a dozen business-travel hotels with 1,000 empty beds on a given night due to the remote work transition. Given these circumstances, do you move to a cheaper region away from your life and community to find a Department of Building approved home? Do you wait for your municipality to build a handful of subsidized housing units, hoping to secure one in a lottery? Do you move into your car or onto the streets because that’s all you can afford? Or do you repurpose the vacant non-residential real estate that’s deteriorating from underuse and draining financial and material resources to stay on-market?

For anyone who’s been unable to afford housing, the answer to the above scenario is as simple as the tent stake one: the imperfect solution is often the best solution when a situation is assessed holistically. Being able to live affordably in your preferred area is a far higher priority than having a proper bathroom in an office building or a proper kitchen in the hotel.

Lofts in Manhattan’s Soho neighborhood (left) were once used for warehousing and manufacturing, but were later converted to residential and retail use after their original functions were no longer needed. A more modern interpretation of this conversion can be found in Alexandria, Virginia’s E-Lofts (right), which converted large office buildings to residential use.

Let’s return to the camping trip, but now all of the stones have been claimed by speculative investors hoping the stones will appreciate on collecting markets. These investors offer to sell you a stone, but you didn’t bring money, and besides, you’re not an accredited stone buyer. They then stop you from using the stones on the ground, citing regulation that limits what one can do with stones to tossing and collecting. Furthermore, demonstrating a stone can be used as a mallet is likely to sink mallet markets, because people realize they can just use a stone. You never get your stone mallet. It’s too late to hike to safety. You freeze to death.

The Capital Market Empty Shell Game

Most contemporary real estate development, investing, and regulation falls into four primary asset classes: residential, commercial (CRE), industrial, and land. Each of those classes has sub-classes: for example, single family and multifamily for residential (though multifamily is sometimes considered commercial); offices and restaurants for commercial; factories and warehouses for industrial; forest and agricultural for land.

Most asset classes have specialized analysts, debt markets, and developers that grow, maintain, and frequently manipulate their performance on Capital Markets. Asset classes are seldom combined in new, useful ways — e.g. putting residential units on agricultural land — since that would theoretically disrupt asset class market stability and likely trigger regulatory issues since most real estate (particularly in the U.S.) is zoned for a single use.

The majority of American real estate is developed in single use zones, like the above single family subdivision (left). By mixing asset classes and geographies (right), REITs can offset losses on under-performing parts of their portfolios with better performing ones. In so doing, individual asset and geographic performance are less important than aggregate performance. Chart via Seeking Alpha.

An investment house like Blackstone might have positions in several asset classes, but those positions are treated more-or-less distinctly — e.g. residential investments are in one silo and commercial another. While invested, developed, and operated distinctly, big investors combine balance sheets in financial structures like real estate investment trusts (REIT), where losses on failing assets classes are offset by gains in booming assets classes like logistic warehouses and made-for-rent single family housing. Similarly, unlike regional developers and investors, REITs can transfer earnings from healthy geographies with lagging ones. These overdeveloped, asset-specific investment engines and creative penciling is why failing assets like offices and business travel hotels will get financed and built only to sit vacant and are not repriced or repurposed.

Tens, if not hundreds of thousands, of units sit empty to maintain their speculative value while rents and homelessness skyrocket.

Diversified real estate investors can also maintain the illusion of asset class performance by constraining supply — i.e. holding some real estate off-market to increase the price on what’s left. One source found 77 percent of all vacant American residential rentals are held off market. Another source found more than 50 percent of unrented apartments in Manhattan were being held off the market. These tactical supply constraints explain how rents can increase while demand decreases; NYC, for example, had a net population migration of 3.5 percent during the pandemic, while median apartment rents rose to record highs. Reduced demand and increased supply is supposed to drive prices down in a free market.

Starting around 2008, the Fed started issuing gobs of free debt in the form of Mortgage Backed Securities (MBS), and today Fed holds ~3 trillion dollars of MBS. Many of these securities are tied to dying asset classes like office and retail.

If withholding vacant real estate — across asset class — became illegal or cost prohibitive through tax penalties, and if regulation allowed for flexible use-cases (e.g. allowing hotels to be used as primary residents), markets would be flooded with spaces. Prices would plummet across asset classes. The “housing crisis” would likely end because those who couldn’t afford single family homes could live in converted hotels or office spaces. There would be an abundance of affordable commercial spaces to support local, small businesses. But Capital Markets focused on outmoded asset classes like luxury rentals and offices would tank. And because the Federal Reserve is so heavily positioned in mortgage backed securities (MBS) tied to these asset classes, the U.S. economy would take a big hit as well.

No Class Real Estate

Now imagine real estate were classless and asset value was assessed individually via a combination of location, design, and potential use-cases, not regulation-restricted or market-validating ones. Classless real estate could be used for residential, office, restaurant, education, child care and adult care — all in one building, depending on the time of day. Would these multi-use spaces have every feature of the single-use ones? No. But just like the tent example, specialization is often synonymous with needless weight and operating resources (i.e. the energy it takes to carry the mallet and the energy and resources it takes to maintain underused real estate). In this classless real estate market, flexible spaces in desirable locations would appreciate in value and utility, while inflexible spaces in remote or unattractive locations would flounder. Considerations would be made for special use-cases like heavy industrial, but the central idea is programming spaces around the manifold and changing needs of real estate users (owners or renters) versus the static financial needs of REITs, fixed asset-class Capital Markets, and the regulators who support them.

The pandemic and remote work have already started a wave of conversions on affected asset classes like hotels and offices to residential (via Quartz).

This declassed real estate market transition could happen, but not before there’s an acknowledgment that the performance of today’s asset-class-based market has come about through the issuance of trillions of dollars of cheap debt and the coordinated inventory manipulation of institutional investors. The most likely force to cause this transition is a market collapse, where a critical mass of defaulted payments will prevent investors from borrowing Peter’s housing rent to pay for Paul’s empty office building mortgage payment. For those of us looking for an affordable home, shop, restaurant, or other space, this collapse can’t come soon enough.

Dear reader, I write stuff like this because it needs to be said and heard, not because it pays — it doesn’t. If you want real and unfiltered real estate insights or a legitimate startup to invest in, I can and would love to help.